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Michael Steinhardt: Variant perception is the effort to become sufficiently knowledgeable about whatever the subject is, that at a time to be at variance from consensus, because one of the few sure ways to make money in the market is to have a view that is off consensus and have that view turned out to be right.

Charlie Rose: Now is that contrarian?

Michael Steinhardt: That’s not enough you have to be right. A contrarian is a plus, but it’s not enough. To be a contrarian is easy, but to be contrarian and to be right in your judgement when the consensus is wrong is where you get the golden ring and it doesn’t happen that much, but when it does happen you make extraordinary amounts of money. And in order to do that you have to be intellectually advantaged. You have to go through that same routine in terms of intensity, focus and commitment and the sorts of things that makes anybody in any area I think superior.

Leon Cooperman on the fallout from the hedge fund industry following the guilty Raj Rajaratnam verdict. Interesting insights on the nuances between ‘insight’ and ‘inside information’ and the overlap between expert knowledge and illegal information.

You know when you invest in a stock and then you try to seek out every reason to validate your investment thesis i.e. ‘this stock is cheap, look how much cash they have on their balance sheet, its year-on-year growth momentum will ensure the company grows into its earnings multiple’ etc; and you phase out almost all negative information about the stock (which may just be the plain reality), well scientists (well not the ones in white lab coats!), have a term for this collective pattern of behaviours, ‘cognitive dissonance’.

A large part of investing is about psychology and sentiment and what drives human behaviour. Cognitive dissonance is perhaps one of the most significant psychological theories with a direct transmission mechanism into investing. Investors purchase stocks long or short because they hold a certain set of beliefs about that stock, even short term investors. Now if markets are efficient information is already in the market and prices should adjust accordingly. Now, unless everyone is trading on inside information they are taking positions based on their interpretation of market information. It is precisely this fact which essentially makes markets.

Cognitive dissonance almost explains why investors typically nurse significant losses on stocks and don’t always sell them even when they have ample opportunities to exit positions incurring only marginal losses. When bad news occurs, damaging fundamentals, the idea of buying into weakness or lowering your average purchase price reinforces this cognitive dissonance behaviour. Instead we should be reconsidering the position itself.

A good example of effectively managing cognitive dissonance behaviour was Whitney Tilson’s Netflix short. Clearly on a financial metric basis the company is overvalued and faces a number of headwinds going forwards. In addition, negative news or general downward market momentum is likely to result in Netflix experiencing deeper stock price losses due to the significant appreciation which has already been achieved to date. However, the company is the premier franchise in online video; international expansion also offers the opportunity to further consolidate their dominant positioning. It would also cost competitors billions to create a bold infrastructure to compete.

Netflix also has first mover advantages and although content costs are high and are expected to increase this is somewhat offset by subscriber growth, and the potential to leverage subscriber price increases. Also any upward guidance is likely to propel the stock artificially higher due to the existing high short interest.

Whitney covered his short and this prevented potential further losses of approx 50%+. He appreciated that his position was not as originally perceived; but there are shorts who have been in Netflix since $70 and the stock has had a parabolic move since then. It is this behaviour of ignoring company and market fundamentals that reflects exactly what cognitive dissonance is. So the next time you see a psychology or social studies book, don’t throw it by the way-side, as it may just contain that small nugget of wisdom hidden behind all that bravado.

Value investing is all about searching for financial securities that are at a discount to their core intrinsic value. They also offer a considerable amount of margin of safety to offset any potential downside. We can extend these concepts further but these are some of the primary features. In order to understand stock movements we need to appreciate market composition, cycles within the economy, macro and micro economic issues, fundamental company-specifics and drivers, including near-term catalysts, and general trading behaviour. As a value investor I don’t pay much attention to short-term technical behaviour such as moving averages, MACD’s, volume and RSI’s. However, it has been estimated that 60% of trading volume is directly attributed to either short-term traders or high frequency algorithms. Therefore, because this group correlates so highly to market performance we need to consider their behaviour and influence.

Short-term technicals overall can generally be viewed as noise rather than having any meaningful value for long-term value investors. The short-term technicals were horrible in March 2009 yet we experienced a generational rally across all stock averages. In terms of technicals I find long term support and resistance indicators as a good barometer for financial instruments. We need to appreciate that there is an underlying fundamental attribute that stock resistance and support levels reflect in terms of market valuation and whether the market is comfortable with that. As always, however, markets are generally inefficient and the market does not always know how to price valuation – the 2000 tech. bubble and the generational March 2009 low highlight this.

To reinforce the point, long-term market behaviour and its directional emphasis is useful and can give clues to future performance. However, viewing technicals in isolation, especially short-term, can be dangerous and is more about speculation and greed rather than investing. It is this type of behaviour and absolute reliance on short-term market performance that almost guarantees continued market volatility and dysfunctional dynamics.

I have been out of the market since 5 April 2011. I believe eventually year-on-year the market will be positive and that opportunities should be capitalised on where value can be exercised. However, with significant gains YTD already and retaining core positions in AGQ, SLV and SU this still gives some exposure to the market. My concerns are that this earnings season is going to be received poorly. We can now see commodity expenses feeding into operating costs which is impacting earnings. The traditional feed downstream into higher price points has not yet taken effect entirely. Companies have had to absorb the majority of input price hikes. As discussed previously I believe there will be a lot of volatility around the time when the national debt ceiling requires increasing and that will impact the stock averages. Eventually it will be passed and that expected downside that is likely to occur prior to agreement should allow a better entry point with more visibility into year-end. Regarding the end of stimulus at the end of June 2011 this is more an issue of semantics rather than material information. The Fed is on a continuous quantitative easing program as it monetises Treasuries but the pace at which this occurs will fall. Without QE2 the incline upwards on the stock market curve will be less pronounced compared to when QE2 was launched. Right now, as discussed, protection should be sought either through an offsetting short position or option hedging to protect from the downside.
A brief note on Gold

I don’t believe there are any weak hands in gold as prices near new nominal highs. My exposure to silver is because of the higher price appreciation propensity the metal traditionally experiences when gold receives positive momentum. The approx 40% industrial component of silver also adds to this complex, however, the downside risk exposure with silver is also greater. Gold is essentially another currency, its price is a reflection of confidence in central banks and is an inverse of total fiat money output. My preference would be to hold precious metals physically rather than an ETF exchange although access to physical holdings is somewhat constrained.

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Fisher investments in their own words are a multi-billion dollar company and one of the world’s largest independent investment advisory firms. They have approximately $40 billion under management. Given the events surrounding Bernie Madoff, the investigations into SAC Capital, the trial and prosecution of Raj Rajaratnam and other hedge funds, financial firms should be pursuing […]

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